The Market for Foreign Exchange

1. 4 Chapter four The Market for Foreign Exchange Chapter Objective: • This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. • This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention. Chapter Outline • Function and Structure of the FOREX Market • The Spot Market • The Forward Market

2. FUNCTION AND STRUCTURE OF FX MARKET • Dispersed broker-dealer or Over the Counter (OTC) market • Size: $1.8 trillion per day • US$ - most trade currency, considered the vehicle currency that expedites transactions between currencies of limited circulation • UK – largest market for foreign exchange (FX) activity

3. FOREIGN EXCHANGE ACTIVITY

4. FOREX Market Participants • The FOREX market is a two-tiered market: • Wholesale (Interbank, 87% of trading volume) and Retail (Client market, 13% of market).  • Why so much wholesale?  • Much wholesale trading is speculative trading (trying to correctly judge the direction of currency values) or arbitrage trading (exploiting ex-rate discrepancies between dealers).  • Currency trading is a profit center for large banks. • Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

5. FOREX Market Participants • 1. INTL BANKS and BANK CUSTOMERS. • 100-200 large commercial banks worldwide provide the core of the FX market and actively participate, • "make a market" in FX, trading FX on behalf of bank customers (MNCs, money managers, exporters, importers, private traders). • Most interbank trades are speculative or arbitrage transactions. 2. NONBANK DEALERS. • Wholesale currency traders who are NOT commercial banks, e.g. Investment banks (Solomon Smith Barney, M-L, JP Morgan, Goldman Sachs, etc.) • establish their own trading centers to trade directly in the FX market, and account for 28% of the interbank (wholesale) volume.

6. FOREX Market Participants • 3. FX BROKERS. • Brokers/intermediaries who track quotes offered by many dealers in the global market, and then match buyers and sellers for a fee (bid/ask spread), and "make a market," without taking a position themselves (no currency inventory).  • More and more trading (50-70%) now takes place through automated electronic trading systems, making the role of FX brokers unnecessary.  • This trend will continue as electronic trading becomes more advanced. 4. CENTRAL BANKS.  • If a country has a fixed ex-rate (Argentina until recently, Hong Kong), or a pegged rate (China), the central bank (or currency board) has to make regular interventions to support the fixed/pegged ex-rate.

7. Correspondent Banking Relationships • Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. • International commercial banks communicate with one another with: • SWIFT: The Society for Worldwide Interbank Financial Telecommunications. • CHIPS: Clearing House Interbank Payments System • ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

8. Spot Rate Quotations • Cash (or spot) market for currency, involves immediate delivery (within one or two days), represents 33% of total FX market.  • Spot rates (S) can be quoted two ways.  Ex-rate is just a ratio of two currencies, can be expressed two ways: S = $/£, or S = £/$.  1.When the domestic currency ($) is on the top, S($/£)=$1.5272/£  it is called: Direct quote; American terms; U.S. $ Equivalent 2. When the foreign currency (£) is on the top S(£/$) =£0.6548/$, it is called: Indirect Quote or European terms, or Currency PER $ • Spot rates are reported both ways.  • Most currencies are priced and traded against the US$ (90% world currency market involves the dollar on one side of transaction),

9. Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 Brazil (Real) 0.2939 0.2879 3.4025 3.4734 Britain (Pound) 1.5627 1.566 0.6399 0.6386 1 Month Forward 1.5596 1.5629 0.6412 0.6398 3 Months Forward 1.5535 1.5568 0.6437 0.6423 6 Months Forward 1.5445 1.5477 0.6475 0.6461 Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1 Month Forward 0.6681 0.6741 1.4968 1.4835 3 Months Forward 0.6658 0.6717 1.502 1.4888 6 Months Forward 0.662 0.6678 1.5106 1.4975 Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote:

10. The Bid-Ask Spread • Bid/Ask Spread provides a commission/brokerage fee for currency traders/brokers.  • The Bid price is the price a dealer is willing to pay for a currency = S(j/kb) • The Ask price is the amount the dealer offers to sell youa currency. It’s the price the dealer wants for the sale of currency = S(j/ka) • Bid-Ask Spread = [Ask price - Bid price] > 0

11. Spot FX trading • In the interbank market, the standard size trade is about US$10 mil. • A bank trading room is a noisy, active place. The stakes are high. • The “long term” is about 10 minutes. • Trading Jargon • Trading Size: $10 million = 10 dollars • Quotation: A$/US$ = A$1.9264 - A$1.9273 • Quote: 64 to 73 (9 point spread) • One dealer’s spread = 66 to 75, what are his/her expectations? • Will have more clients selling US$ to dealer for A$ • Expects US$ to appreciate, therefore building up inventory in US$ • Currency Nicknames: Cable, Loonie, Aussie, Swissie, Greenback, Sing dollar, Kiwi

12. CROSS FX-RATE QUOTATIONS • Cross Ex-Rate is an ex-rate that does NOT involve $, e.g. €/£.  See cross currency rates on page 86. Example: S(€/£) = S($/£) / S($/€) = S($/£) x  S(€/$), so S =  €/£ (The $s cancel, leaving €/£).Assume: S($/£) = 1.6944 and S($/€) = 1.1584 So S($/£) = 1.6944 / 1.1584 =  €1.4627/£.        S($/€)

13. Triangular Arbitrage Suppose we observe these banks posting these exchange rates. $ Credit Lyonnais S(£/$)=0.60 Barclays S(€/$)=0.95 Credit Agricole S(€/£)=1.65 € First calculate the implied cross rates to see if an arbitrage exists. £

14. Triangular Arbitrage The implied S(€/£) cross rate is S(€/£) =1.5833 $ $ Credit Lyonnais S(£/$)=0.60 Credit Agricole has posted a quote of S(€/£)=1.65 so there is an arbitrage opportunity. Barclays S(€/$)=0.95 3 1 2 Credit Agricole S(€/£)=1.65 € £ So,how can we make money? As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for €, 3. Sell those € for $.

15. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 0.60 receive £60,000 Sell our £ 60,000 for € at S(€/£)= 1.65 receive €99,000 Sell €99,000 for $ at S(€/$) = 0.95 receive $104,210 profit per round trip = $ 104,210- $100,000 = $4,210

16. Spot Foreign Exchange Microstructure • Market Microstructure are the mechanics of how a marketplace operates. • Spot mkt Bid-Ask spreads • increase with FX exchange rate volatility and decrease with dealer competition. • Private information is an important determinant of spot exchange rates. - Mkt adjusts to econ info in 1min. - 1/3 of traders claim adjustment < 10 sec - Central bank intervention does not work; it increase volatility.

17. Forward market • Contract settled today for future delivery/receipt of FX.  • Agree today on P (fx-rate) and Q, future settlement in 1, 3, 6, 9, 12 months, 2, 5, 10 years, etc..  • Forward rates are available for most major currencies at most maturities. • Compared to the spot rate, FX is usually trading at either a Forward Discount (currency is expected to depreciate) or Forward Premium (currency is expected to appreciate).

18. Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 Brazil (Real) 0.2939 0.2879 3.4025 3.4734 Britain (Pound) 1.5627 1.566 0.6399 0.6386 1 Month Forward 1.5596 1.5629 0.6412 0.6398 3 Months Forward 1.5535 1.5568 0.6437 0.6423 6 Months Forward 1.5445 1.5477 0.6475 0.6461 Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1 Month Forward 0.6681 0.6741 1.4968 1.4835 3 Months Forward 0.6658 0.6717 1.502 1.4888 6 Months Forward 0.662 0.6678 1.5106 1.4975 Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months.

19. Long and Short Forward Positions • If you have agreed to sell anything (spot or forward), you are “short”. • If you have agreed to buy anything (forward or spot), you are “long”. • If you have agreed to sell FX forward, you are short. • If you have agreed to buy FX forward, you are long.

20. Payoff Profiles ($/SF) profit Since this is a zero-sum game, the long position payoff is the opposite of the short. Long position F3($/SF) S3($/SF) 0 .6700 F3($/SF) =.6670 -.0030 S3 > F3 results in a loss of the Short position -F3($/SF) Short position loss

21. Forward Cross Exchange Rates • It’s just a “delayed” example of the spot cross rate discussed above. • In generic terms

22. Forward Premium • It’s just the interest rate differential implied by forward premium or discount. • For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307 • The forward premium is given by:

23. SWAP TRANSACTIONS • A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency. • Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. • Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent. • Forward bid-ask prices are usually quoted in terms of forward points. See example 4.5